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Proposed regulations thwart a capital-gain-avoidance plan. The plan purports to avoid capital gain for a life (or term-of-years) beneficiary of a charitable remainder unitrust (CRUT) or annuity trust (CRAT) on a sale to a third party by the life beneficiary and the charitable remainder organization of their respective interests.
The proposed regulations follow up on a 2008 IRS Notice, in which the Treasury and the IRS (from now on, I’ll mostly just say the IRS) described the plan (scheme?), required notification to the IRS by participants and costly penalties imposed for non-notification.
Before getting to the proposed regulations, here's background helpful in understanding them and assuaging concerns about early termination of charitable remainder trusts (CRTs) in typical “non-abuse” situations.
Stepped-up basis—general rule. For appreciated assets inherited at death, an heir gets a basis equal to the then fair market value (FMV) (rather than taking over the decedent’s lower basis). But, a decedent has to give his life to achieve this favorable status.
Can the beneficiary of a CRUT or CRAT during his lifetime step up the basis of appreciated assets used to fund the trust (and any other trust assets) and then, on an early termination of the trust, receive proceeds equal to his interest in the trust free of capital gains tax? That’s what concerned the IRS in Notice 2008-99 and in the recently proposed regulations that are the subject of this article. (Although “proposed,” the final regulations are unlikely to have any substantive changes.)
Three scenarios follow. Scenario 3 won’t deliver the hoped-for benefits. Scenarios 1 and 2 don’t concern the IRS and shouldn’t concern you.
Scenario 1—no problem. Every schoolchild knows that a donor can transfer appreciated assets to a CRUT or CRAT, avoid capital gain on the trust’s funding and not be taxed on the capital gain on a subsequent sale by the trust. The capital gain is, however, taxable to the donor or other beneficiary, but only to the extent that the gain is deemed distributed to the beneficiary under the four-tier taxation regime in satisfaction of the annual unitrust or annuity amount.
Scenario 2—no problem. Some beneficiaries terminate their CRTs before the end of the specified term, and the trust assets are divided between the beneficiary and the charitable remainder organization according to their respective interests at the CRT’s termination. A number of letter rulings have sanctioned this division. The termination is treated as a sale of a capital asset, not to a third party, of the beneficiary’s term interest (generally measured by his life but sometimes a term-of-years). The beneficiary is deemed to have a zero basis and a capital gain. If the trust was created more than one year before its termination, the gain is taxed favorably.
Scenario 3—a problem. The IRS announced, in Notice 2008-99, that it was aware of a transaction (described soon) in which a sale or other disposition of all interests in a charitable remainder trust (subsequent to the contribution of appreciated assets to the trust and their sale and reinvestment by the trust) resulted in the donor or other non-charitable beneficiary getting the value of that person’s trust interest and claiming to recognize little or no taxable gain. “The IRS and Treasury Department believe this transaction has the potential for tax avoidance or evasion*, but lack enough information to determine whether the transaction should be identified specifically as a tax avoidance transaction.” The IRS identified this transaction and substantially similar transactions as being of interest for purposes of Reg. Section 1.6011-4(b)(6) and Internal Revenue Code Sections 6111 and 6112. The IRS also alerted persons involved in these transactions to certain responsibilities that may arise from their involvement. More about transactions of interest, listed transactions and reportable transactions later. To keep this article from becoming a book, I won’t explain all the Code and regulation sections cited in Notice 2008-99 regarding required notifications to the IRS. Suffice it to say if you’re involved in this type of transaction, you’ll want to study them.
Here’s the transaction of interest to the IRS. Step 1. A donor creates a CRUT or CRAT and contributes appreciated assets to the trust. The donor retains an annuity or unitrust interest (the term interest) and designates a charity as the remainder organization. The charity may, but need not, be controlled by the donor; he may, but need not, reserve the right to change the charity designated as the remainder beneficiary.
Step 2. The CRT sells or liquidates the appreciated assets and reinvests the net proceeds in other assets (new assets), such as money market funds and marketable securities, often to acquire a diversified portfolio. Because a charitable remainder trust is tax-exempt under IRC Section 664, the trust’s sale of the appreciated assets is exempt from income tax, and the trust’s basis in the new assets is the price the trust pays for those new assets. Some portion of the trust’s ordinary income and capital gains may become taxable to the term recipient as the periodic annuity or unitrust payments are made (under the rules of IRC Section 664 and its regulations).
Step 3. The donor and the charity, in a transaction they claim is described in IRC Section 1001(e)(3), sell or otherwise dispose of their respective interests in the trust to an unrelated third party for approximately the FMV of the trust’s assets including the new assets.
Step 4. The trust then terminates, and the trust’s assets, including the new assets, are distributed to the unrelated third party.
The donor takes these positions regarding the tax consequences of this transaction:
• The donor claims an income tax charitable deduction for the portion of the FMV of the appreciated assets attributable to the remainder interest as of the date of their contribution to the trust.
• The donor claims to recognize no gain from the trust’s sale or the liquidation of the appreciated assets. When the donor and the charity sell their respective interests in the trust to the unrelated third party, the donor and the charity take the position that they have sold the entire interest in the trust within the meaning of IRC Section 1001(e)(3). Because the entire interest in the trust is sold, the donor claims that IRC Section 1001(e)(1), which disregards basis in the case of a sale of just the term interest, doesn’t apply. The donor also takes the position that, under IRC Section 1001(a) and related provisions, the gain on the sale of the donor’s term interest is computed by taking into account the portion of uniform basis allocable to the donor’s term interest under Reg. Sections 1.1014-5 and 1.1015-1(b) and that this uniform basis is derived from the basis of the new assets rather than the basis of the appreciated assets. (If this technique works, the donor has achieved Tax Nirvana—a stepped-up basis without giving his life.)
Variations on a scheme:
• A net-income-with-make-up charitable remainder unitrust (NIMCRUT) is used.
• Trust may have been in existence for some time prior to the sale of trust interests.
• The appreciated assets may already be in the trust before the commencement of the transaction.
• The beneficiary and the seller of the term interest may be the donor and/or another person.
• The donor may contribute the appreciated assets to a partnership or other passthrough entity and then contribute the interest in the entity to the trust.
Claimed tax treatment of the transaction. The gain on the sale of the appreciated assets is never taxed, even though the donor receives his share of the appreciated FMV of those assets.
Ordinary folks needn’t worry. The IRS and the Treasury aren’t concerned about the mere creation and funding of a CRT with appreciated assets and/or the trust’s reinvestment of the contributed appreciated assets. Those events alone don’t constitute the transaction subject to Notice 2008-99. And the proposed regulations echo this sentiment.
Who should be concerned? The IRS and the Treasury:
"… are concerned about the manipulation of the uniform basis rules to avoid tax on gain from the sale or other disposition of appreciated assets. Accordingly, the type of transaction described in this notice includes a coordinated sale or other coordinated disposition of the respective interests of the [donor] or other noncharitable [beneficiary] and the charity in a charitable remainder trust in a transaction claimed to be described in §1001(e)(3), subsequent to the contribution of appreciated assets and the trust’s reinvestment of those assets. In particular, the IRS and Treasury Department are concerned about [donor’s] claim to an increased basis in the term interest coupled with the termination of the trust in a single coordinated transaction under §1001(e) to avoid tax on gain from the sale or other disposition of the Appreciated Assets."
Notice 2008-99's teeth—transactions of interest. Transactions that are the same as, or substantially similar to, those described in Notice 2008-99 “are identified as transactions of interest for purposes of §1.6011-4(b)(6) and §§6111 and 6112 effective October 31, 2008, the date this notice was released to the public. Persons entering into these transactions on or after November 2, 2006, must disclose the transaction as described in §1.6011-4. Material advisors who make a tax statement on or after November 2, 2006, with respect to transactions entered into on or after November 2, 2006, have disclosure and list maintenance obligations under §§6111 and 6112. See §1.6011-4(h) and §§301.6111-3(i) and 301.6112-1(g) of the Procedure and Administration Regulations.” The proposed regulations say that these teeth continue to bite.
The IRS’s warning—participants who entered into these transactions at any time may already be in hot water:
"Independent of their classification as transactions of interest, transactions that are the same as, or substantially similar to, the transaction described in this notice already may be subject to the requirements of §§6011, 6111, or 6112, or the regulations thereunder. When the IRS and Treasury Department have gathered enough information to make an informed decision as to whether this transaction is a tax avoidance type of transaction, the IRS and Treasury Department may take one or more actions, including removing the transaction from the transactions of interest category in published guidance, designating the transaction as a listed transaction, or providing a new category of reportable transaction."
Who are participants?
"Under §1.6011-4(c)(3)(I)(E), each recipient of the term interest and Trust are participants in this transaction for each year in which their respective tax returns reflect tax consequences or a tax strategy described in this notice. Charity is not a participant if it sold or otherwise disposed of its interest in Trust on or prior to October 31, 2008. For interests sold or otherwise disposed of after October 31, 2008, under §1.6011-4(c)(3)(I)(E), Charity is a participant for the first year for which Charity’s tax return reflects or is required to reflect the sale or other disposition of Charity’s interest in Trust. In general, Charity is required to report the sale or other disposition of its interest in Trust on its return for the year of the sale or other disposition. See §6033 and §1.6033-2(a)(ii). Therefore, in general, Charity will be a participant for the year in which charity sells or otherwise disposes of its interest in Trust.”
Time for Disclosure. See Reg. Sections 1.6011-4(e) and 301.6111-3(e).
Material Advisor Threshold Amount. The threshold amounts in Reg. Section 301.6111-3(b)(3)(I)(B) are reduced to $5,000.
Penalties—the book will be thrown at those who are required to disclose but don’t.
“Persons required to disclose these transactions under §1.6011-4 who fail to do so may be subject to the penalty under §6707A. Persons required to disclose these transactions under §6111 who fail to do so may be subject to the penalty under §6707(a). Persons required to maintain lists of advisees under §6112 who fail to do so (or who fail to provide such lists when requested by the IRS) may be subject to the penalty under §6708(a). In addition, the IRS may impose other penalties on parties involved in these transactions or substantially similar transactions, including the accuracy-related penalty under §6662 or §6662A.”
THE PROPOSED REGULATIONS
Background and explanations published in the proposed regulations.
Charitable Remainder Trusts
A CRT is a trust that provides for the distribution of an annuity or a unitrust amount, at least annually, to one or more beneficiaries, at least one of which is not a charity, for life or for a limited term of years, with an irrevocable remainder interest held for the benefit of, or paid over to, charity. Thus, there's at least one current income beneficiary of a CRT and a charitable remainder beneficiary. A CRT isn't subject to income tax. See IRC Section 664(c).
Uniform Basis Rule
Property acquired by a trust from a decedent or as a gift generally has a uniform basis. This means that property has a single basis even though more than one person has an interest in that property. See Reg. Sections 1.1014-4(a)(1) and 1.1015-1(b). Generally, the uniform basis of assets transferred to a trust is determined under IRC Section 1015 for assets transferred by lifetime gift or under IRC Sections 1014 or 1022 for assets transferred from a decedent. Adjustments to uniform basis for items such as depreciation are made even though more than one person holds an interest in the property (adjusted uniform basis).
When a taxable trust sells assets, any gain is taxed currently to the trust, one or more beneficiaries or apportioned among the trust and its beneficiaries. If the trust reinvests the proceeds from the sale in new assets, the trust’s basis in the newly purchased assets is the cost of the new assets. See IRC Section 1012. Thus, the adjusted uniform basis of that taxable trust is attributable to basis obtained with proceeds from sales that were subject to income tax.
However, a CRT does not pay income tax on gain from the sale of appreciated assets. A CRT may sell appreciated assets and accumulate undistributed income and undistributed capital gains and may reinvest the proceeds of the sales in new assets. The treatment of distributions from a CRT to its income beneficiary depends upon the amount of undistributed income and undistributed capital gains in the CRT. See IRC Sections 664(b)(1) and (2).
Basis in Term and Remainder Interests in a CRT
IRC Section 1001(e) governs the determination of gain or loss from the sale or disposition of a term interest in property, such as a life or term interest in a CRT. In general, IRC Section 1001(e)(1) provides that the portion of the adjusted basis of a term interest in property that's determined pursuant to IRC Sections 1014, 1015 or 1041 is disregarded in determining gain or loss from the sale or other disposition of such term interest. Thus, the seller of such an interest, generally, must disregard that portion of the basis in the transferred interest in computing the gain or loss.
IRC Section 1001(e)(3), however, provides that IRC Section 1001(e)(1) doesn't apply to a sale or other disposition that's part of a transaction in which the entire interest in property is transferred. Therefore, in the case of a sale or other disposition that's part of a transaction in which all interests in the property (or trust) are transferred as described in IRC Section 1001(e)(3), the capital gain or loss of each seller of an interest is the excess of the amount realized from the sale of that interest over the seller’s basis in that interest. Each seller’s basis is the seller’s portion of the adjusted uniform basis assignable to the interest so transferred. See Reg. Section 1.1014-5(a)(1).
The basis of a term or remainder interest in a trust at the time of its sale or other disposition is determined under the rules provided in Reg. Section 1.1014-5. See also Reg. Sections 1.1015-1(b) and 1.1015-2(a)(2), which refer to the rules of Reg. Section 1.1014-5. Specifically, Reg. Section 1.1014-5(a)(3) provides that, in determining the basis in a term or remainder interest in property at the time of the interest’s sale or disposition, adjusted uniform basis is allocated using the factors for valuing life estates and remainder interests. Thus, the portions of the adjusted uniform basis attributable to the interests of the life tenant and remaindermen are adjusted to reflect the change in the relative values of such interests due to the lapse of time.
The IRS discusses Notice 2008-99 detailed at the outset of this article. It then explains the proposed regulations.
"[The] proposed regulations provide a special rule for determining the basis in certain CRT term interests in transactions to which section 1001(e)(3) applies. In these cases, the proposed regulations provide that the basis of a term interest of a taxable beneficiary is the portion of the adjusted uniform basis assignable to that interest reduced by the portion of the sum of the following amounts assignable to that interest: (1) the amount of undistributed net ordinary income described in section 664(b)(1); and (2) the amount of undistributed net capital gain described in section 664(b)(2). These proposed regulations do not affect the CRT’s basis in its assets, but rather are for the purpose of determining a taxable beneficiary’s gain arising from a transaction described in section 1001(e)(3). However, the IRS and the Treasury Department may consider whether there should be any change in the treatment of the charitable remainderman participating in such a transaction … Additionally, the IRS and the Treasury Department believe that rules addressing early terminations other than those arising from a transaction described in section 1001(e)(3), and rules prescribing valuation methods, are beyond the scope of the issues intended to be addressed in these proposed regulations, and thus will not be considered as part of this guidance … Finally, the rules in these proposed regulations are limited in application to charitable remainder annuity trusts and charitable remainder unitrusts as defined in section 664. The IRS and the Treasury Department request comments as to whether the rules also should apply to other types of tax-exempt trusts."
The issuance of these proposed regulations does not affect the disclosure obligation set forth in Notice 2008-99.
THE PROPOSED REGULATIONS WITH EXAMPLES
(c) Sale or other disposition of a term interest in a tax-exempt trust--(1) In general. In the case of any sale or other disposition by a taxable beneficiary of a term interest (as defined in §1.1001-1(f)(2)) in a tax-exempt trust (as described in paragraph (c)(2) of this section) to which section 1001(e)(3) applies, the taxable beneficiary’s share of adjusted uniform basis, determined as of (and immediately before) the sale or
disposition of that interest, is--
(i) That part of the adjusted uniform basis assignable to the term interest of the taxable beneficiary under the rules of paragraph (a) of this section reduced, but not below zero, by
(ii) An amount determined by applying the same actuarial share applied in paragraph (c)(1)(i) of this section to the sum of--
(A) The trust’s undistributed net ordinary income within the meaning of section 664(b)(1) and §1.664-1(d)(1)(ii)(a)(1) for the current and prior taxable years of the trust, if any; and
(B) The trust’s undistributed net capital gains within the meaning of section 664(b)(2) and §1.664-1(d)(1)(ii)(a)(2) for the current and prior taxable years of the trust, if any.
(2) Tax-exempt trust defined. For purposes of this section, the term tax-exempt trust means a charitable remainder annuity trust or a charitable remainder unitrust as defined in section 664.
(3) Taxable beneficiary defined. For purposes of this section, the term taxable beneficiary means any person other than an organization described in section 170(c) or exempt from taxation under section 501(a).
(4) Effective/applicability date. This paragraph (c) and paragraph (d), Example 7 and Example 8, of this section apply to sales and other dispositions of interests in tax exempt trusts occurring on or after January 17, 2014, except for sales or dispositions occurring pursuant to a binding commitment entered into before January 17, 2014.
(d) * * *
Example 7. (a) Grantor creates a charitable remainder unitrust (CRUT) on Date 1 in which Grantor retains a unitrust interest and irrevocably transfers the remainder interest to Charity. Grantor is an individual taxpayer subject to income tax. CRUT meets the requirements of section 664 and is exempt from income tax.
(b) Grantor’s basis in the shares of X stock used to fund CRUT is $10x. On Date 2, CRUT sells the X stock for $100x. The $90x of gain is exempt from income tax under section 664(c)(1). On Date 3, CRUT uses the $100x proceeds from its sale of the X stock to purchase Y stock. On Date 4, CRUT sells the Y stock for $110x. The $10x of gain on the sale of the Y stock is exempt from income tax under section 664(c)(1). On Date 5, CRUT uses the $110x proceeds from its sale of Y stock to buy Z stock. On Date 5, CRUT’s basis in its assets is $110x and CRUT’s total undistributed net capital gains are $100x.
(c) Later, when the fair market value of CRUT’s assets is $150x and CRUT has no undistributed net ordinary income, Grantor and Charity sell all of their interests in CRUT to a third person. Grantor receives $100x for the retained unitrust interest, and Charity receives $50x for its interest. Because the entire interest in CRUT is transferred to the third person, section 1001(e)(3) prevents section 1001(e)(1) from applying to the transaction. Therefore, Grantor’s gain on the sale of the retained unitrust interest in CRUT is determined under section 1001(a), which provides that Grantor’s gain on the sale of that interest is the excess of the amount realized, $100x, over Grantor’s adjusted basis in the interest.
(d) Grantor’s adjusted basis in the unitrust interest in CRUT is that portion of CRUT’s adjusted uniform basis that is assignable to Grantor’s interest under §1.1014-5, which is Grantor’s actuarial share of the adjusted uniform basis. In this case, CRUT’s adjusted uniform basis in its sole asset, the Z stock, is $110x. However, paragraph (c)
of this section applies to the transaction. Therefore, Grantor’s actuarial share of CRUT’s adjusted uniform basis (determined by applying the factors set forth in the tables contained in §20.2031-7 of this chapter) is reduced by an amount determined by applying the same factors to the sum of CRUT’s $0 of undistributed net ordinary income and its $100x of undistributed net capital gains.
(e) In determining Charity’s share of the adjusted uniform basis, Charity applies the factors set forth in the tables contained in §20.2031-7 of this chapter to the full $110x of basis.
Example 8. (a) Grantor creates a charitable remainder annuity trust (CRAT) on Date 1 in which Grantor retains an annuity interest and irrevocably transfers the remainder interest to Charity. Grantor is an individual taxpayer subject to income tax. CRAT meets the requirements of section 664 and is exempt from income tax.
(b) Grantor funds CRAT with shares of X stock having a basis of $50x. On Date 2, CRAT sells the X stock for $150x. The $100x of gain is exempt from income tax under section 664(c)(1). On Date 3, CRAT distributes $10x to Grantor, and uses the remaining $140x of net proceeds from its sale of the X stock to purchase Y stock. Grantor treats the $10x distribution as capital gain, so that CRAT’s remaining undistributed net capital gains amount described in section 664(b)(2) and §1.664-1(d) is $90x.
(c) On Date 4, when the fair market value of CRAT’s assets, which consist entirely of the Y stock, is still $140x, Grantor and Charity sell all of their interests in CRAT to a third person. Grantor receives $126x for the retained annuity interest, and Charity receives $14x for its remainder interest. Because the entire interest in CRAT is transferred to the third person, section 1001(e)(3) prevents section 1001(e)(1) from applying to the transaction. Therefore, Grantor’s gain on the sale of the retained annuity interest in CRAT is determined under section 1001(a), which provides that Grantor’s gain on the sale of that interest is the excess of the amount realized, $126x, over Grantor’s adjusted basis in that interest.
(d) Grantor’s adjusted basis in the annuity interest in CRAT is that portion of CRAT’s adjusted uniform basis that is assignable to Grantor’s interest under §1.1014-5, which is Grantor’s actuarial share of the adjusted uniform basis. In this case, CRAT’s adjusted uniform basis in its sole asset, the Y stock, is $140x. However, paragraph (c)
of this section applies to the transaction. Therefore, Grantor’s actuarial share of CRAT’s adjusted uniform basis (determined by applying the factors set forth in the tables contained in §20.2031-7 of this chapter) is reduced by an amount determined by applying the same factors to the sum of CRAT’s $0 of undistributed net ordinary income and its $90x of undistributed net capital gains.
(e) In determining Charity’s share of the adjusted uniform basis, Charity applies the factors set forth in the tables contained in §20.2031-7 of this chapter to determine its actuarial share of the full $140x of basis.
REG-154890-03 in 79 Fed. Reg. 3142 (January 17, 2014)
Comments and Requests for Public Hearing: Before the proposed regulations are adopted as final, consideration will be given to any written (a signed original and 8 copies) or electronic comments that are submitted timely to the IRS. The IRS and the Treasury Department also request comments on the administrability and clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying at www.regulations.gov or upon request. A public hearing will be scheduled if requested in writing by any person who timely submits written or electronic comments. If a public hearing is scheduled, notice of the date, time, and place of the public hearing will be published in the Federal Register.
Written or electronic comments and requests for a public hearing must be received by April 17, 2014.
Send submissions to CC:PA:LPD:PR (REG-154890-03), room 5205,Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, D.C., 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-154890-03), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C., or send electronically via the Federal eRulemaking Portal at www.regulations.gov (IRS REG-154890-03).
For further information contact: Concerning the proposed regulations, Allison R. Carmody at (202) 317-5279; concerning submissions of comments and requests for hearing, Oluwafunmilayo (Funmi) Taylor, at (202) 317-6901.
Proposed Effective/Applicability Date. Sales and other dispositions of interests in CRTs occurring on or after Jan. 17, 2014, except for sales or dispositions occurring pursuant to a binding commitment entered into before Jan. 17, 2014. However, the inapplicability of these regulations to an excepted sale or disposition does not preclude the IRS from applying legal available arguments to the IRS before issuance of these regulations in order to contest the claimed tax treatment of such a transaction.
Drafting Information: The principal author of the proposed regulations is Allison R. Carmody of the Office of Associate Chief Counsel (Passthroughs and Special Industries). Other personnel from the IRS and the Treasury Department participated in their development.
*Evasion is more serious than avoidance. Avoidance can be achieved by taking advantage of tax-saving methods specified in the Code. Sometimes it is achieved by a loophole (something that Congress didn’t think of — but kosher until the loophole is closed by legislation, regulation, revenue ruling, etc.). Tax evasion, on the other hand, can end you up in a federal gated community.
© Conrad Teitell 2014. This is not intended as legal, tax, financial or other advice. So, check with your advisor on how the rules apply to you.